Threshold Effects in the Relationship between Inflation and Economic Growth in Kenya: 1970-2014

Abstract

It is widely agreed among economists, policy makers and central bankers that all macroeconomic policies seek to attain high levels of economic growth coupled with very low rates of inflation. High inflation rates have resulted to a number of adverse effects on the economic growth of many countries over time. But how low should the inflation rate be so as not to affect economic growth negatively? Economic policymakers in Kenya have been working towards the attainment of a 5 percent rate of inflation as the most ideal rate for economic policy purposes. Is this rate of inflation the most appropriate for economic growth? Recent studies have demonstrated that, inflation only causes detrimental effects in an economy in the event it rises beyond a specific threshold depending on the level of economic development of an economy and the existing economic structure. If the level of inflation is below the identified threshold, then the effect of inflation on economic growth is insignificant or even positive. In an attempt to determine whether or not there existed threshold effects between these two variables of interest in Kenya, this study assumed that economic growth and inflation had a non-linear relationship and used quarterly data spanning the sample period 1970-2014. This study sought;to determine if a first threshold inflation level exists in the relationship between inflation and economic growth in Kenya; to determine if a second threshold inflation level exists in the relationship between economic growth and inflation rate in Kenya; to establish the effect of inflation on the level of economic growth at the estimated lower and upper threshold levels of inflation in Kenya; and to analyze the impact of a structural break on the threshold regression model for the Kenyan economy. A suitable regression model for the threshold was used in this study. The results revealed the existence of two significant threshold levels at 6.1318% and 9.6274%. Inflation causedpositive and significant effects on economic growth at inflation rates below the first threshold level. The effect of inflation on economic growth was also positive and significant at all inflation rates between the two threshold levels. However, at inflation rates above the second threshold level, inflation had a negative effect on the level of economic growth. This study also showed that failure to account for structural breaks in the relationship between economic growth and inflation largely influenced the estimated effects of inflation on growth at the identified threshold levels. The findings of this study provide an important basis for the formulation of monetary policy in Kenya given that they act as a guide in the setting of inflation targets. The findings further provide economic policymakers in Kenya with consistent guidance on matters of inflation in the actualization of long-term economic growth targets.